Parties Never Last, Hangovers Do!

``The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.”- Warren Buffett

The risks remain out there in spite of the snowballing sanguine expectations.

Figure 2: IMF: Philippine Peso and the VIX Index

In figure 2, courtesy of the IMF, the Philippine Peso (dotted line) has appreciated amidst the backdrop of a RECORD low volatility, low signs of anxiety and high-risk appetite conditions as represented by the VIX Index.

Figure 3: IMF: Appreciation pf Regional Currencies Against the US Dollar

And as I have likewise pointed out in the past, the rising Peso has been a regional phenomenon as shown in Figure 3, again from the IMF. Growth in forex reserve surpluses, increasing rate of (portfolio) investment flows, surging remittances, greater official cooperation, regionalization trends and/or increased economic and financial integration have served as the key impetus, aside from of course, as beneficiary to the global carry trade and a structurally weakening US dollar.

Figure 4: IMF: Rollover and Exchange Risks in Public Debt

The Philippine financial markets seems to be pricing in conditions where the low key reporter Clark Kent turns himself into Superman! Yet, all these could be illusory or smoke and mirrors as global inflationary policies heavily distort risk pricing activities by investors whose goal had been no less than to hunt for expanded returns, no matter the risks involved.

While there is no question that the present efforts of reforms instituted by the incumbent administration has significantly improved the country’s finances and fiscal position, a boatload of work remains to be done.

In Figure 4, the IMF reminds us that the Philippines remains as the region’s MOST VULNERABLE relative to Debt to GDP risk, Exchange Rate risk and Rollover exposed debt to GDP. Wrote the IMF (emphasis mine), ``As a result of recent reforms continued robust growth, and the more appreciated exchange rate, staff expect NFPS (Non-Financial Public Sector) debt to have fallen below 80 percent of GDP by end-2006, compared to 100 percent at end-2003. External debt is expected to have declined by a similar order of magnitude. Nonetheless, the Philippines remains vulnerable to a sudden reversal in global risk appetite, as rollover and exchange risk remain high.”

And this is what I’ve been saying all along. Today’s tsunami of capital has prompted both the private and public institutions, particularly the emerging trend of state investment companies to manage excess reserves, into expand their investing universe, to even consider illiquid and exotic themes, in order to squeeze out returns in a world faced with diminishing returns due to extensive competition and adaptation of similar investing approaches.

Furthermore, the introduction of innovative instruments such as derivatives, structured products and other forms of sophisticated trading strategies has compounded this outlook. As we have discussed before, in order to expand returns more leverage are being applied to magnify returns.

For instance, in our past issues we delved about the added liquidity brought about by the provisions of the carry trade arbitrage, where according to the Financial Times, ``households in Latvia and Romania have developed so much enthusiasm for borrowing in yen.” This means the carry trade has now turned increasingly global and more widespread to include unsophisticated households.

As record short positions have been taken against the “funding” currencies of the Japanese Yen and the Swiss Franc, demand for high yield instruments as the New Zealand’s dollar have caused a surge in the bond issuance of KIWI, adds Peter Garnham, Gillian Tett and David Turner of the Financial Times (emphasis mine), ``To take one out-of-the-way corner of global finance, the amount of bonds denominated in New Zealand dollars by European and Asian issuers has almost quadrupled in the past couple of years to record highs. This NZ$55bn (US$38bn, £19bn, €29bn) mountain of so-called "eurokiwi" and "uridashi" bonds towers over the country's NZ$39bn gross domestic product - a pattern that is unusual in global markets.” Incredible.

While this has so far reduced the volatility in New Zealand’s currency or any asset beneficiaries of the carry trade by way of offsetting the risks via hedging through derivatives, the world has been consistently adding tremendous amount of leverage which may at one point pose as a systemic risk or destabilize the global financial markets and the world economy.

Derivative trades, like any typical trades work on two ways, a buyer and seller, while such aims to reduce risks by dispersion one thing we shouldn’t forget is that there is always someone on the other side who will absorb the risks.

And I think this phenomenon is adding to the speculative inflows into our region and our local asset class.

Table 1: Guinness Atkinson’s Asia Brief: Asia’s PE

Aside from China and Hong Kong which had been mentioned earlier, on a year to date basis here is how the region fared: New Zealand +3.07%, Australia +5%, Taiwan -1.82%, South Korea +1.0%, Thailand +1.2%, Indonesia -.62%, Japan/Nikkei +3.77%, Singapore +8.4% and Malaysia +15.13%.

As you can see in Table 1, relative to PE ratios, the Phisix is situated on the HIGH end among its regional contemporaries in 2006. Whereas its earnings growth is expected to outperform the region for 2007 and 2008, the present gains appear to have almost consumed the expected growth rate. The same dynamics can be said of with the outperformance of Malaysia and Singapore, as well as, China. This essentially means that today’s star performers appear to be more richly valued relative to its peers.

Like your analyst, the Guinness Atkinson team remains bullish on Asian assets over the long term where they noted that (emphasis mine) `` it is the outlook for Asia’s domestic demand that is a key issue for future investment prospects and strategy. It also helps us understand why Asian central banks have been reluctant to allow too rapid a rise in their currencies while local demand remains fragile. Inflation in the region is subdued (including Indonesia where it has fallen sharply in the last couple of months to 6.6%) and should remain so until domestic demand picks up.”

Figure 4: Daily Wealth: Emerging Markets as Expensive as Ever!

Finally in figure 4, Daily Wealth Dr Steve Sjuggerud thinks that emerging market stocks are overbought, overvalued and way extended after having breached twice the Book Value of its underlying assets.

In other words, as our markets continue to head higher, the risks of sharper adjustments by way of precipitate correction increases. Parties never last, hangovers do.